Remember the great rotation? Bond yields at historic lows and an improving growth environment were expected to drive investors out of fixed income and into equities at the start of 2013, but the prediction never came to pass.
In part, this was due to the realisation that growth wasn’t all it was cracked up to be. It was also because, for investors, it was never as simple as a straight swap between equities and fixed income.
But two years later, concerns over bonds remain – not least because they have continued to post stellar returns in the interim. The question now for asset allocators is exactly how they will replace this exposure, and the answer is both nuanced and uncertain.
Risk budgets mean bonds will never fall fully out of fashion, even at a time when concerns over valuations, liquidity, and duration are painting a pretty dismal picture for the asset class. The other difficulty is a lack of many viable alternatives.
As Ingenious Asset Management chief investment officer Guy Bowles explained: “The fascinating thing is […] where do we put fixed income money. There is no right or wrong answer”.
In any case, the gradual move out of fixed income remains just that: gradual. Investec Wealth & Investment, for example, attracted headlines earlier this year when it announced it was shifting part of its fixed income allocation into alternatives.
“The switch was driven by the belief that these alternative investments can be sensible options for reducing portfolio volatility when the more conventional options (in fixed income) become excessively expensive,” the company said.
Nonetheless, the wealth manager decreased its exposure to index-linked gilts and cash by just 1 per cent each, using this money to up its allocation to alternative investments such as hedge funds, absolute return funds and defensive structured products.
Ingenious’s Bowles, meanwhile, values qualities such as liquidity, transparency and low volatility, which lead him to higher cash weightings but also absolute return funds.
“[Replacing fixed income allocations] involves a compromise. Some firms decide not to compromise on anything and hold cash. Some compromise on liquidity and hold infrastructure. We didn’t feel happy about that. If a client phones on Monday, I want to be able to give them [their cash] on Friday.”
Meena Lakshmanan, head of investment solutions at Vestra Wealth, notes of the current conundrum: “It is not enough to just say, ‘I’m going to be low duration.’ You also need to be careful about how you are positioned within the curve.”
As equity markets wobble again this summer, it is worth pointing out that as of September 22, the £ High Yield, £ Strategic Bond and UK Gilts sectors had all eked out positive returns for the year – albeit perhaps not of the magnitude expected given stocks’ falls. All three have posted average returns of just under 1 per cent.
Ironically, it is this kind of return which has so attracted investors to low-risk absolute return bond portfolios in recent months: not so much slow and steady as deathly dull.
The overriding concern is avoiding capital loss. Strategic bond funds were once seen as the answer to more testing times for bonds, but as the bull market has continued, some now see preserving capital as even more important than producing income. That means the kind of return that sometimes appears closer to that of a money market fund than a go-anywhere ‘strategic’ offering.
The Kames Capital Absolute Return Bond fund, for example, has produced a three-year return of 4.5 per cent and been hugely popular with investors, amassing £1.5bn in assets since its launch in 2011.
Similarly, BlackRock’s Absolute Return Bond fund, which is even more cautious in its objective – has grown to £400m in size since launch and returned just 2.2 per cent over the past three years.
Elsewhere, Ms Lakshmanan said fully-fledged hedge funds – such as event-driven or global macro strategies – can be a replacement allocation for ‘directional’ fixed income exposure such as the truly strategic bond funds.
These strategies are designed to have a low sensitivity to both bonds and equities. The change, as Mr Bowles suggested and Ms Lakshmanan agreed, is the greater degree of liquidity risk involved.
The yield provided by conventional fixed income funds remains too important to forego entirely. This demand means any future changes to allocations will remain marginal rather than fully fledged.
Ms Lakshmanan concluded: “You cannot write off fixed income completely. The capital appreciation and risk of capital loss is not the same as [in] the days of 15 per cent yields, but you just need to be a bit more discerning about your investments.”
